As the first chapter of the Bre-X circus closes – with fake gold ore samples, bodies flying out of airplanes, money transfers from Brazil to Indonesia – we should forgive Canadian investors for thinking that they are bit players in a Pythonesque drama.

The courts tell them to seek their remedies with the regulators; the regulators tell them to go see the legislators, who pass them on to the common law courts, which refuse to recognize any general ‘fraud on the market’ theory.

In law, the financial statements of an enterprise belong to it and not to its shareholders. Who, if anyone, is liable for any material misstatement in the financial statements?

In most lawsuits, the plaintiff is either a creditor or an investor. Typically, the complainant alleges that she lost money because corporate management was not diligent, did not use generally accepted accounting principles (GAAP) or the auditors did not comply with generally accepted auditing standards (GAAS) to detect material errors in the financial statements.

What is the scope of each party’s liability for material errors in the financials?

The general representation letter that auditors require from management states that the latter is entirely responsible for the preparation of the financial information. The auditor’s opinion is just that: an opinion that the financial statements present fairly the results of operations and the financial position of the enterprise. The audit is not insurance against fraud.

Nevertheless, there are many lawsuits against accounting firms involving claims for unfair financial statements. In part, the economics of litigation drive some lawsuits. Accounting firms – especially the Big Four – have substantial professional liability insurance policies and are a natural target for disgruntled creditors and investors. Most settle their lawsuits confidentially and without admission of liability. Few cases ever get to court.

Public accountants also practice law and perform a variety of legal services – for example, tax planning, insolvency services, etc.. However, their primary function of financial auditing is the service that most frequently triggers lawsuits against them.

Although a business may commission an audit for a variety of purposes, public companies use audited financial statements to establish their credibility with third parties.

Existing and prospective investors, financial institutions, and creditors base their decisions on the economic viability of the enterprise with which they do business. Indeed, financial statements that bear the stamp of approval of one of the Big Four are a sine qua non to raising capital in the public markets.

Under Canadian law, however, liability for negligent misstatement is virtually impossible to establish. An accountant is liable only if he is in a proximate relationship with the plaintiff and there is no policy basis to limit his liability.

The first aspect of the rule protects against lawsuits by parties who do not have a direct relationship with the accountant. Although it is not necessary to have a contractual relationship with the auditor to sustain a third party suit against him, the parties must at least be in a proximate relationship.

The second aspect of the rule is entirely policy driven by 1930s law. The policy restrictions derive from the decision of Chief Judge Benjamin Cardozo in his opinion for the New York Court of Appeals in Ultramares, where the creditor made three unsecured loans totalling $165,000 to a company that went bankrupt.

The plaintiff sued the company’s auditors, claiming reliance on their audit opinion that the company’s balance sheet “presented a true and correct view of the financial condition” of the firm.

In fact, although the balance sheet showed a net worth of $1 million, the company was insolvent.  The company’s management masked its financial condition; the auditors failed to follow paper trails to ‘off-the books’ transactions – remember Enron – that, if properly analyzed, would have revealed the company’s impecunious situation.

The auditor knew that the company was in need of capital and that it would use the audit opinion in its financial dealings with third parties. However, the company did not mention the plaintiff’s name to the auditors, nor tell them of any proposed credit or investment transactions.

The Court of Appeals held that the auditor did not owe a duty to the third party creditor for “an erroneous opinion.” Cardozo considered it inappropriate to hold the accountants liable “in an indeterminate amount for an indeterminate time to an indeterminate class”.

To hold accountants liable in these circumstances would create an unwarranted hazard for the accounting business and not serve the best interests of society.

Faced with a similar problem 66 years later, the Supreme Court of Canada in Hercules adopted Cardozo: absent special considerations, auditors of public companies owe their duty to the collectivity of shareholders but not to investors making personal investment decisions.

The court agreed that although holding auditors liable would act as a deterrent, it would be “socially undesirable” to impose liability for an indeterminate amount and an indeterminate time to an indeterminate class. Social policy trumped deterrence to effectively block claims of negligence causing economic loss by individual investors.

Combined with the fragmented regime of securities regulation in Canada and the absence of a ‘fraud on the market’ doctrine, Hercules virtually immunizes auditors of public companies from investor lawsuits. Instead, Canadians must rely on their common law remedy of misrepresentation, which requires proof of knowledge in every case.

Although recent statutory changes in Ontario have opened the door to new theories of securities tort liability, the new statutory process is restrictive and unlikely to provide investors with broad protection. Thus, Canadian investors remain as bit players in the Flying Circus.